difference between profit maximization and shareholder wealth maximization

1. Discuss the difference between profit maximization and shareholder wealth maximization. Which of these is a more comprehensive statement of a company’s economic objectives?

2. Briefly discuss the Coase theorem. What does this theory imply about the role of government in dealing with market externalities?

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3. Question not applicable (No Answer needed)

4. Question not applicable (No Answer needed)

5. Mr. Lee operates a green grocery in a building he owns in one of the outer boroughs of New York City. Recently, a large chemical firm offered him a position as a senior engineer designing plants for its Asian operations. (Mr. Lee has a master’s degree in chemical engineering.) His salary plus benefits would be $95,000 per year. A recent annual financial statement of his store’s operations indicates the following:

Revenue $625,000
Cost of goods sold 325,000
Wages of workers 75,000
Taxes, insurance, maintenance 30,000
and depreciation on building
Interest on business loan (10%) 5,000
Other miscellaneous expenses 15,000
Profit before taxes $175,000

If Mr. Lee decides to take the job, he knows that he can sell the store for $350,000 because of the goodwill built with a steady clientele of neighborhood customers and the excellent location of the building. He would still hold on to the building, however, and he knows he could earn a rent of $50,000 on this asset. If he did sell the business, assume he would use some of the proceeds from the sale to pay off his business loan of $50,000. He could then invest the difference of $300,000 (i.e., $350,000 – $50,000) and expect to receive an annual return of 9 percent.

Should Mr. Lee sell his business and go to work for the chemical company?

In answering this question, also consider the following information:

a. In his own business, Mr. Lee works between 16 and 18 hours a day, 6 days a week. He can expect to work between 10 and 12 hours a day, 5 days a week, in the chemical company.

b. Currently, Mr. Lee is assisted by his wife and his brother, both of whom receive no salary but share in the profits of the business.

c. Mr. Lee expects his salary and the profits of his business to increase at roughly the same rate over the next 5 years.

6. In the following list are a number of well-known companies and the products that they sell. Which of the four types of markets (perfect competition, monopoly, monopolistic competition, and oligopoly) best characterizes the markets in which they compete?

a. McDonald’s hamburgers

b. Exxon Mobil gasoline

c. Dell personal computers

d. Heinz ketchup

e. Procter & Gamble disposable diapers

f. Kodak photographic film

g. Starbucks gourmet coffee

h. Domino’s pizza

i. Intel computer chip for the PC

Solution Preview
1. Profit maximization is a strategy that looks at maximizing the dollar value of total profits, while shareholder wealth maximization looks at maximizing marginal profit. Thus the first is an aggregate concept, and the second is a marginal concept. The second one is more important from a financial perspective since investors are looking at return on their investment, and in this case they are more concerned with the marginal profit than with aggregate profit.

For example, consider two firms in the same business. One is a giant that has sales worth $5 billion and profit after tax of $500 million. The other has sales worth $500 million and profits after tax of $150 million. Now the first firm has higher profits, but total profit is 10% of total sales. The second one has lower profits, but is more efficient with profits at 30% of total sales. For an investor the second option is better since the returns per dollar are higher. Most companies today aim at maximizing share-holder value, rather than profits, since investors are concerned about the return on their investment.

Shareholder value maximization is probably a better indicator of the health of the company since every penny you invest is getting a higher return. So if you are saving something from investing in a smaller company you can use that to fund other projects and hope to get higher returns. As is the case in economics virtually every decision you make is based on the marginal advantage of doing that (remember marginal benefits …

Solution Summary
The difference between profit maximization and shareholder wealth maximization is highlighted.

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